V.9:12 (505-507): Assessing Risk In An Equity Portfolio by Jean-Olivier Fraisse, C.F.A.
Product Description
Assessing Risk In An Equity Portfolio
by Jean-Olivier Fraisse, C.F.A.
Portfolio management is a balancing act — enhancing returns by systematically investing in the most promising assets while simultaneously limiting the variance of returns (that is, risk). What is the nature of investment risk in an equity portfolio and how is it measured?
When considering an asset for inclusion in a portfolio, most investors will focus on the asset's expected total return and on the variance of returns. While high expected returns are desirable, a large variance implies a wide dispersion of returns, and thus, a high level of risk (see sidebar, "Assessing a single equity placement").
When combining several investments into a portfolio, the expected return for the portfolio is the average of the returns on the individual assets, duly weighted by each asset's cost in relation to total portfolio cost. The variance of portfolio returns, however, bears no simple relationship with the variance of returns on the individual assets, because the returns on any two assets may peak and ebb at the same time, increasing the variance of portfolio returns; or they may compensate for each other, the return on one asset peaking while the other is ebbing, thus reducing the variance of portfolio returns. The relationship between two assets' returns is captured by their coefficient of correlation, which measures the direction and degree of association of their return fluctuations, and their covariance, which measures the magnitude of the fluctuations for the combined assets. (The corresponding formulas are shown in sidebar, "Measuring association between returns on two assets.")
Portfolio management is a balancing act — enhancing returns by systematically investing in the most promising assets while simultaneously limiting the variance of returns (that is, risk). What is the nature of investment risk in an equity portfolio and how is it measured?
When considering an asset for inclusion in a portfolio, most investors will focus on the asset's expected total return and on the variance of returns. While high expected returns are desirable, a large variance implies a wide dispersion of returns, and thus, a high level of risk (see sidebar, "Assessing a single equity placement").
When combining several investments into a portfolio, the expected return for the portfolio is the average of the returns on the individual assets, duly weighted by each asset's cost in relation to total portfolio cost. The variance of portfolio returns, however, bears no simple relationship with the variance of returns on the individual assets, because the returns on any two assets may peak and ebb at the same time, increasing the variance of portfolio returns; or they may compensate for each other, the return on one asset peaking while the other is ebbing, thus reducing the variance of portfolio returns. The relationship between two assets' returns is captured by their coefficient of correlation, which measures the direction and degree of association of their return fluctuations, and their covariance, which measures the magnitude of the fluctuations for the combined assets. (The corresponding formulas are shown in sidebar, "Measuring association between returns on two assets.")
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